Bond Investors Could Pay for Part of J.P. Morgan’s Settlement

Investors in mortgage-backed securities asked Attorney General Eric Holder last month not to structure a legal settlement over mortgage wrongdoing in a way that would stick those investors with some of the tab.

But the $13 billion settlement that J.P. Morgan signed with the U.S. government on Tuesday opens the door — again — to bank write-downs of mortgages in bonds that are owned by other investors.

Under the deal announced by the Department of Justice, J.P. Morgan agreed to provide consumer relief valued at $4 billion. At least half of that relief must consist of either mortgage write-downs or other modifications that defer payments on a portion of the loan principal for borrowers who are struggling to make their payments or are at risk of foreclosure.

The amount of mortgages subject to write-downs varies depending on which loans it modifies and how quickly it modifies them. At least $1.2 billion of the relief must consist of write-downs of first-lien mortgages, with $1 of credit for every $1 that it writes down. But if J.P. Morgan modifies loans on its books by next October, it receives 15% additional credit, or $1.15 for every $1 in write-downs. If it modifies portfolio-held loans in certain “hard hit” regions, it receives a 25% bonus.

J.P. Morgan can also get partial credit of 50% for modifications of loans it doesn’t actually own but rather manages monthly payments on behalf of other investors. Combining the other formulas, that translates to $0.575 per $1 in modifications before October 2014, $0.625 per $1 in hard-hit areas and so on, for loans the bank doesn’t actually own.

At an industry conference last week, investors cited such settlements as an example of “anti-investor” policies that have hindered the return of private capital into the mortgage market. “We’ve had a series of government settlements with no investors at the table, and in fact, you have settlements allowing the servicer to take money out of investors’ pockets and use that toward their stated goal of modifications,” said Barbara Novick, managing director at BlackRock Inc.

A government lawyer who wasn’t authorized to speak publicly about the settlement defended it on Wednesday. He said the government took strong steps to ensure that the main victims of predatory lending and other abuses from the financial bust—homeowners—have an opportunity to receive some remedies. Confining the consumer-relief portion of the settlement only to loans held on J.P. Morgan’s books would have unnecessarily constrained those benefits to borrowers.

A spokeswoman for J.P. Morgan declined to comment. Government and bank officials have previously defended the structure of these settlements by saying that they can only take place when banks determine that write-downs are in the best interest of investors.

The Association of Mortgage Investors, a trade group that represents some 25 major mortgage-bond investors, sent a letter to Mr. Holder last month asking that the government not allow investors to shoulder any costs of penalties for the bank’s settlement of alleged misconduct.

“Parties sued by the government or third-parties should not be able to settle with assets that they do not own, namely other people’s money,” wrote Chris Katopis, the association’s executive director. Mr. Katopis declined to comment on Tuesday.

Despite unhappiness with the terms, mortgage investors have grown accustomed to these sorts of settlements by now. Three previous mortgage-related settlements have allowed banks to receive at least partial settlement credit by approving loan-balance reductions for homeowners whose mortgages aren’t owned by the bank but are managed on behalf of other investors.

Last year, federal agencies and 49 state attorneys general agreed to a settlement worth $25 billion with five banks, including J.P. Morgan, to settle allegations of improper foreclosure practices known as “robo-signing.” Banks had to pay $5 billion in penalties and provide $20 billion in consumer relief, including principal write-downs. Under that deal, banks can receive partial credit for reducing balances on loans they don’t own but instead manage, or “service,” on behalf of private investors.

At the time, federal officials had said that no more than 15% of such write-downs would come out of loans held by third parties, though banks didn’t have to agree to any binding limit. Bank of America Corp. said that 41% of the credit it was eligible to receive at the end of last year covered loans serviced on behalf of third parties, while J.P. Morgan said that 32% of its credits reflected consumer-relief for loans serviced for other investors, according to court filings made last month by the independent monitor of that settlement.